Municipal Pathologies Come to a Head

Discussions about municipal finance generally assume three absolute conditions.
First, the principal and coupon of municipal bonds are guaranteed: "Municipal
bonds don't default," according to trusted experts. Second, the guarantees
are backed by the taxing authority of the state or municipality. Third, accrued
pension benefits are guaranteed.

It is universally believed (and rightly so) that services provided to those
who pay taxes are not guaranteed. In this formulation, the taxpayers are the
true victims of injudicious and ignorant spending on the part of municipal
governments. Federal government mandates, often injudicious and ignorant, are
an additional burden.

The rigidity of these categorizations led to poor decisions. Believing in
an absolute world, lazy and pusillanimous mayors, legislators, and public union
negotiators bid up benefits that cannot be honored. These multi-decade illusions
are coming to a head.

Recent government solvency problems in Dubai and Greece raised the American
public's conscious of possible bond defaults. This is in the wake of domestic
budget problems that have gained attention over the past year.(See AuContrarian.com "articles" section: "The
Coming Collapse of the Municipal Bond Market.") The travails of governors
and mayors in California, New York and almost every other state have swelled
to the point that credit-default swap spreads are wider now for some states
than for Greece and Spain.

These relative assessments (of greater default risk among the states than
of Greece) are not necessarily correct. The degree to which the spendthrift
European Union and the spendthrift Obama Administration shovel money, credit
lines and guarantees to prop up the spendthrift municipalities is unknown.
It is also unknown, at least to the public, which European banks are on the
cusp of failure, at a time when bank customers are moving money to safe havens.
Panic could move quickly across the Atlantic when it is recognized how many
U.S. banks that Deserve to Fail (DTF) have large exposures to European banks
that DTF.

Many municipalities will find themselves in desperate straits if lenders,
particularly bond buyers, step away from the market. The tendencies are apparent.
(Bloomberg News, July 2, 2010 - "The Metropolitan Transit Authority,
which runs New York City's subways, buses and commuter trains, shrank a $555
million taxable bond offering by 16% as it struggled with a deficit and as
investors sought to avoid risk.") The National Association of Budget Managers
estimates that fiscal year 2010 (which ended June 30, 2010) cash balances have
shrunk to 2.2% of expenditures, excluding Alaska and Texas. If the bond market
shuts down, city workers may be paid in scrip rather than money, as often happened
during the Great Depression.

We should not expect emergency steps to make sense, whether or not the trigger
is as described above. Just as at the federal level, the political and financial
leadership is mostly the same that created this crisis. A problem that is not
understood cannot be solved by those who do not understand it. A battle-scarred
veteran of municipal finance boards wrote to me: "During my time on two pension
boards, the boards did less as the problems got worse. Board members tend to
be town employees caught in the headlights. They are not financially trained,
and they tend to believe rather unsophisticated consultants who all say the
same thing: 'You can earn your way out in 15 years.' This is not true. Not
even compounding can save you when benefits are rising faster than the return
on assets. We have yet to begin to seriously attack this problem. The most
we have done is 'tried' to initiate cuts of annual percentage increases in
benefits." [Lazy and pusillanimous pension consultants deserve notoriety on
the list above.]

Having, myself, spent nearly two decades meeting with municipal pension committees,
I saw that the incapacity to pay future pensions, already evident in 1988,
grew to mathematically insolvable proportions. Most cities and states, as well
as the media reports about those entities, are so far short of understanding
the depth of this cavern that they are examples of Bernankeism. (Federal Reserve
Chairman Ben Bernanke: "U.S. households have been managing their personal finances
well." - June 13, 2006)

To remain solvent, bloated pension benefits need to be cut severely. This
is not being considered. News stories of public sector pension cuts are mostly
aimed at future employees or future service of current employees. There are
stories of concessions being made by current retirees that will reduce current
benefits, but this is not clear, short of reading the new contracts.

As we enter the sinking-lifeboat period, imagination is constricted. Consumers
of municipal services are expected to bear the burden. This assumption will
spark revolts. The reduction in public services is already an annoyance. Consistently
decreasing non-government income is more than an annoyance. Private income
in the U.S., which excludes federal, state and local pay, fell 5.4% from the
third quarter of 2008 to April 2010.

There are municipalities where property tax rates have been doubled recently
to absorb the deficit. It is at such moments when taxpayers remind municipal
boards that all government revenue comes from the taxpayers. Tax strikes in
the past, such as in Chicago from 1928 to 1931 and again in 1977, succeeded.

Whatever the future holds, there are two certainties. First, this is another
leg in the deleveraging of American credit, which should not be ignored by
economists trying to tease a recovery out of the already corrupted and overstated
GDP. Second, only seasoned participants should still be holding municipal bonds.

Sheehan serves as an advisor to investment firms and endowments. He is the
former Director of Asset Allocation Services at John Hancock Financial Services
where he set investment policy and asset allocation for institutional pension
plans. For more than a decade, Sheehan wrote the monthly "Market Outlook" and
quarterly "Market Review" for John Hancock clients.

Sheehan earned an MBA from Columbia Business School and a BS from the U.S.
Naval Academy. He is a Chartered Financial Analyst.